One safe haven for investors has been the essential-services sector of the tax-exempt market. These "essential" water, power, and sewer bonds are widely regarded as some of the soundest municipals available.

Communities cannot exist without services like water and power. Therefore, the revenue stream from these services is safer and more reliable compared to other, more volatile types of revenue issuers, like hospitals, stadiums, and airports.

But safer and more reliable does not mean a complete absence of risk. Many municipalities are hurting financially, and in some cases their problems are spilling over into water, sewer, and power agencies.

How did this happen? One cause is the home-foreclosure crisis. Foreclosure-riddled areas now have empty houses.

Empty houses means fewer households are paying for water, power, and sewer services. Revenues fell, but the infrastructure costs remain fixed at the high levels that assumed full occupancy.

Some housing developments that sprang up just before the credit crisis are ghost towns today…and ghosts don’t pay property taxes. Such problems are mostly concentrated in California, Arizona, Nevada, and Florida, but few states have avoided the problem completely.

One recent example of a troubled essential-service issuer is Clovis, California, a residential community northeast of Fresno. Like many other areas in California’s Central Valley, growth in Clovis has been stagnant since the credit crisis. The local wastewater service is largely dependent on connection-fee revenues.

The problem is, in Clovis’ shrinking economy, no new homes are being connected. This causes connection-fee revenues to deteriorate significantly.

For the $94 million outstanding in Clovis’ wastewater bonds, Moody’s recently enacted a multi-notch downgrade on the bonds, from A1 to Baa2. This was quite a shock to the bondholders.

3 Rules To Finding Good Bonds
Investors should follow three important rules when selecting essential-service bonds:

Buy bonds from mature, well-off areas.

Bonds from well-established communities have probably already survived economic downturns and have stable populations. Avoid essential service bonds of newly developed communities or those experiencing high rates of foreclosure. Clovis is a good example of why not to buy the bonds of newly developing communities.

Avoid bonds with derivatives or interest-rate swaps.

Swaps are common in essential-services bonds because they supposedly lower the interest or other costs of the issuer. But in a few cases, the hedging was actually an unsuccessful gamble on interest rates or commodity prices.

For example, in Jefferson County, Alabama, the county engaged in swaps with major investment banks as a money-saving strategy. It backfired. Now the county is on the hook for hundreds of millions in unanticipated costs.

Bond buyers can avoid such risks by examining the official statement or ratings report to see if the bond issue has any outstanding swap contracts. If so, avoid them.

Buy only the senior debt of essential services.

Many issuers have various tiers of bonds within their debt structure. Some rank higher (the senior debt) in the priority of repayment than others.

Bonds to avoid are the more junior, or subordinated debt, as they take a back seat to the senior debt in order of repayment should a bankruptcy occur. Senior debt owners have a much better chance of being made whole.

To sum up, essential-service bonds can be great additions to municipal portfolios, but use caution and common sense when selecting them. Stick with these three rules. You’ll have less anxiety over the financial stability of your holdings.